How your pension could pay off your debts

Using tax-free cash could make sense, but beware of 'liberation' schemes.

Nearly one in five people who plan to retire in 2013 have unpaid credit card and mortgage debtsPhoto: Andrew Compton / Alamy

By Harvey Jones

6:45AM GMT 06 Mar 2013

If you're one of the growing number of people heading towards retirement with spiralling debt, you may have one weapon left in your arsenal: your pension.

Releasing some of your company or personal pension early can seem like an easy way to clear debt. The decision to launch an early raid on your pension shouldn't be taken lightly – such plans can easily backfire, leaving you far less money to retire on.

You also have to watch out for rogue advisers, who have been conning people into "liberating" their retirement savings early through unauthorised schemes.

Pensioner debt is a growing problem. Nearly one in five people who plan to retire in 2013 have unpaid credit card and mortgage debts averaging a hefty £31,200, according to Prudential. Their debt repayments cost £215 a month on average, a major burden after you stop working and your regular income dries up.

Most people should leave their entire pension to grow until they are ready to stop working at 65 or later, but there are exceptions, said Jamie Smith-Thompson, managing director at independent financial advisers Portal Financial Services. "If you have expensive debts, you should consider clearing them using some or all of your 25pc tax-free lump sum, while leaving the balance invested for the future."

You can make your pension money work harder by using it to pay down costly debts rather than leaving it invested, Mr Thompson said. "Say you are paying interest at 15pc to 20pc on a credit card, or 10pc to 12pc on a business loan. Your pension won't grow by anything like that amount, so it may be sensible financial planning to release some of it to pay off that debt."

You can continue paying into the pension from your regular income to top up any lost value, and claim tax relief on your contributions. But HM Revenue & Customs rules prevent you from recycling that tax-free cash back into a pension.

You should only raid your pension if you can't afford to clear the debts from your regular income, other savings and investments, or an inheritance, Mr Thompson said. "But an awful lot of over-55s don't have this option, and debt casts a real shadow over their life. Using a tax-free pension lump sum in this way can be liberating, it's a pity more people don't know about this option."

He said this option worked for both personal pensions and workplace money-purchase pensions, but is rarely suitable for final salary pension schemes.

You don't have to take all your pension benefits at once, said Andrew Tully, pensions technical director at MGM Advantage. "You can phase those benefits, taking some of your tax-free cash and income at an earlier age, while leaving the remainder in your pot for when you finally stop working. Remember, this will leave less for when you retire, so make sure you understand the full implications."

Graham Tracey, a chartered financial planner at Carpenter Rees, the advisory firm, said: "Pension-pot raiding is not something we'd encourage. Plunging annuity rates, the rising state pension age and increasing life expectancy make it difficult enough to save for a comfortable retirement, even if you leave your pot intact."

Using your tax-free cash to clear expensive debts is one thing, but Mr Tracey said you should never draw your pension early to clear your mortgage, make home improvements or help children fund university fees or get on the property ladder, for example.

Business owners are sometimes tempted to use their pension lump sum to invest in their enterprise, but this is risky. "There may be better options. For example, you might be able to raise the money by setting up a special type of pension called a small self-administered scheme (SSAS), without taking the benefits early," Mr Tracey said.

Taking tax-free cash from your pension can also trigger a change in the scheme's death benefits if you die soon afterwards, warned Simon Nicol, pension director at Broadstone Corporate Benefits. "If you die without touching your pension, the whole fund will pass tax-free to your beneficiaries. But if you have previously taken some of your pension, the balance could be subject to a tax charge of 55pc. You should therefore think twice about unlocking your pension early if you are in poor health."

The decision to dip into your pension early shouldn't be taken lightly, said Jonathon Webb, sales director at JLT Wealth Management. "Don't do anything without considering your full personal financial circumstances and taking independent financial advice."